With 2016 not getting off to an auspicious start in most asset classes, many investors may wonder whether we are heading into a new era – one where investment yields across many asset classes are lower than they have been in recent history. If so, this means that investors need to pay increased attention to their portfolio allocations in order to get the most mileage possible from their investments.
2015 Was Disappointing for Most Asset Classes
Almost every investment asset class disappointed in 2015, as did global economic growth generally. Investors in developed country stock markets roughly broke even. Emerging markets were even worse, with their popularity waning as commodity price losses took their toll on countries that were net exporters of raw materials.
Government bond markets have also suffered a small loss, although those that put their money into the benchmark ten-year Treasury bond actually eked out a small gain. Commodities have been among the worst performers; even gold is down 10% on the year. The weakness in energy prices has yet to spur developed countries to a boom, and has even dampened investment somewhat since commodity producers had previously been responsible for a healthy portion of global capital expenditures.
Many commentators have argued that we are returning to a historical pattern that had been in place for years prior to the 1970-2007 period of relatively high interest rates. “We’re returning to normal, and it’s just taken time for people to realize that,” said Bryan Taylor, chief economist of Global Financial Data, which scours old records to calculate historical financial data. “I think interest rates are going to stay low for several decades.”
Investment returns come from two sources: income and capital gains. The income portion is much lower than it used to be. The yield on long-dated Treasury bonds 25 years ago was more than 8%; but now the yield on the ten-year Treasury bond is just 2.3%. Yields on corporate bonds, which pay a spread over government debt, have fallen in tandem.
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Corporate profits have also been affected. Fourth-quarter profits at S&P 500 companies are likely to have fallen by 3.6% year on year; even without financial and energy stocks, profits would be up by just 0.1%. In the absence of higher profits, stock markets need higher valuations if they are to generate positive returns. But Wall Street started 2015 on a cyclically-adjusted price-earnings ratio of 26.8, compared with the historical average of 16.6, according to Professor Robert Shiller of Yale University, and it will likely end the year at nearly the same figure.
Commercial Real Estate Is Still Rolling Along
As a result, some investors have been turning to commercial real estate because of its potential to generate higher returns, particularly since real estate crowdfunding firms like the company I work with have made these investments more accessible to individual investors. Even riskier projects are drawing significant interest. Morgan Stanley, for example, recently raised over $1.7 billion for its first higher-risk real-estate fund since 2007, a sign that its real estate operations have finally recovered from the downturn. The new global fund has attracted commitments from investors such as CIC and Australia’s sovereign-wealth fund. “There’s a ton of capital chasing real estate in every market in every nook and cranny,” said John Klopp, co-chief executive of the real-estate unit at Morgan Stanley.
Commercial real estate fundamentals — such as demand, occupancy and rents — remain strong, which has kept property values up in the private market, said Steven Marks, a managing director at Fitch Ratings who specializes in U.S. REITs. Indeed, the long-term returns from property look very respectable; in the ten years to last September, American commercial property delivered a total annualized return of 7.9%, according to IPD, a property-information group.
There is a risk of a forming bubble, of course. One reason investors might welcome the Fed’s recent increase in interest rates is that the recent low-interest rate environment has arguably been heating up the commercial real estate market too rapidly.
Yet despite the action in commercial real estate, debt levels across the broader financial system are still modest. Overall U.S. financial sector debt— $15.2 trillion in the second quarter—was down 16% from the third quarter of 2008. Financial sector debt has fallen to 84% of economic output from 125%, a sign that the economy is less prone to a financial crisis on the scale of 2008. Moreover, a boom that had surfaced in junk bonds now shows signs of fizzling; prices are now tumbling, while borrowing costs and defaults on this debt are rising.
Looking Good by Comparison
Investing in commercial real estate is not without risk. But the alternatives are not very attractive, particularly as forecasts for corporate profits growth are at their weakest since July 2012. And the theory that low interest rates will be the norm going forward has some credibility. The Fed’s official median forecast for short-term interest rates over the long term is a mere 3.5 percent. If anything, financial markets think even this is too optimistic; thirty-year Treasury bonds are currently yielding 2.9 percent, implying that markets expect that long-term rate will be even lower than Fed officials expect over the coming decades.
Compared to a few years ago, commercial real estate no longer looks undervalued. But the prospects of most other asset classes look dismal by comparison.
